In this section we are concerned only with inflation and credit expansion. For the sake of simplicity we assume that the whole additional amount of money and money-substitutes flows into the loan market and reaches the rest of the market only via the loans granted. This corresponds precisely to the conditions of an expansion of circulation credit.5 Our scrutiny thus amounts to an analysis of the process caused by credit expansion.
In dealing with this analysis, we must refer again to the price premium. It has been mentioned already that at the very beginning of a credit expansion no positive price premium arises. A price premium cannot appear until the additional supply of money (in the broader sense) has already begun to affect the prices of commodities and services. But as long as credit expansion goes on and additional quantities of fiduciary media are hurled on the loan market, there continues a pressure upon the gross market rate of interest. The gross market rate would have to rise on account of the positive price premium which, with the progress of the expansionist process, would have to rise continually. But as credit expansion goes on, the gross market rate continues to lag behind the height at which it would cover both originary interest plus the positive price premium.
It is necessary to stress this point because it explodes the customary methods according to which people distinguish between what they consider low and high rates of interest. It is usual to take into account merely the arithmetical height of the rates or the trend which appears in their movement. Public opinion has definite ideas about a “normal” rate, something between 3 and 5 per cent. When the market rate rises above this height or when the market rates—without regard to their arithmetical ratio—are rising above their previous height, people believe that they are right in speaking of high or rising interest rates. As against these errors, it is necessary to emphasize that under the conditions of a general rise in prices (drop in the monetary unit's purchasing power) the gross market rate of interest can be considered as unchanged with regard to conditions of a period of a by and large unchanging purchasing power only if it includes a by and large adequate positive price premium. In this sense, the German Reichsbank's discount rate of 90 per cent was, in the fall of 192 3, a low rate—indeed a ridiculously low rate—as it considerably lagged behind the price premium and did not leave anything for the other components of the gross market rate of interest. Essentially the same phenomenon manifests itself in every instance of a prolonged credit expansion. Gross market rates of interest rise in the further course of every expansion, but they are nonetheless low as they do not correspond to the height required by the expected further general rise in prices.
In analyzing the process of credit expansion, suppose we assume that the economic system's process of adjustment to the market data and of movement toward the establishment of final prices and interest rates is disturbed by the appearance of a new datum, namely, an additional quantity of fiduciary media offered on the loan market. At the gross market rate which prevailed on the eve of this disturbance, all those who were ready to borrow money at this rate, due allowance being made for the entrepreneurial component of each instance, could borrow as much as they wanted. Additional loans can be placed only at a lower gross market rate. It does not matter whether this drop in the gross market rate expresses itself in an arithmetical drop in the percentage stipulated in the loan contracts. It could happen that the nominal interest rates remain unchanged and that the expansion manifests itself in the fact that at these rates loans are negotiated which would not have been made before on account of the height of the entrepreneurial component included. Such an outcome too amounts to a drop in gross market rates and brings about the same consequences.
A drop in the gross market rate of interest affects the entrepreneur's calculation concerning the chances of the profitability of projects considered. Along with the prices of the material factors of production, wage rates, and the anticipated future prices of the products, interest rates are items that enter into the planning businessman's calculation. The result of this calculation shows the businessman whether or not a definite project will pay. It shows him what investments can be made under the given state of the ratio in the public's valuation of future goods as against present goods. It brings his actions into agreement with this valuation. It prevents him from embarking upon projects the realization of which would be disapproved by the public because of the length of the waiting time they require. It forces him to employ the available stock of capital goods in such a way as to satisfy best the most urgent wants of the consumers.
But now the drop in interest rates falsifies the businessman's calculation. Although the amount of capital goods available did not increase, the calculation employs figures which would be utilizable only if such an increase had taken place. The result of such calculations is therefore misleading. They make some projects appear profitable and realizable which a correct calculation, based on an interest rate not manipulated by credit expansion, would have shown as unrealizable. Entrepreneurs embark upon the execution of such projects. Business activities are stimulated. A boom begins.
The additional demand on the part of the expanding entrepreneurs tends to raise the prices of producers' goods and wage rates. With the rise in wage rates the prices of consumers' goods rise too. Besides, the entrepreneurs are contributing a share to the rise in the prices of consumers' goods as they too, deluded by the illusory gains which their business accounts show, are ready to consume more. The general upswing in prices spreads optimism. If only the prices of producers' goods had risen and those of consumers' goods had not been affected, the entrepreneurs would have become embarrassed. They would have had doubts concerning the soundness of their plans, as the rise in costs of production would have upset their calculations. But they are reassured by the fact that the demand for consumers' goods is intensified and makes it possible to expand sales in spite of rising prices. Thus they are confident that production will pay, notwithstanding the higher costs it involves. They are resolved to go on.
Of course, in order to continue production on the enlarged scale brought about by the expansion of credit, all entrepreneurs, those who did expand their activities no less than those who produce only within the limits in which they produced previously, need additional funds as the costs of production are now higher. If the credit expansion consists merely in a single, not repeated injection of a definite amount of fiduciary media into the loan market and then ceases altogether, the boom must very soon stop. The entrepreneurs cannot procure the funds they need for the further conduct of their ventures. The gross market rate of interest rises because the increased demand for loans is not counterpoised by a corresponding increase in the quantity of money available for lending. Commodity prices drop because some entrepreneurs are selling inventories and others abstain from buying. The size of business activities shrinks again. The boom ends because the forces which brought it about are no longer in operation. The additional quantity of circulation credit has exhausted its operation upon prices and wage rates. Prices, wage rates, and the various individuals' cash holdings are adjusted to the new money relation; they move toward the final state which corresponds to this money relation, without being disturbed by further injections of additional fiduciary media. The rate of originary interest which is coordinated to this new structure of the market acts with full momentum upon the gross market rate of interest. The gross market rate is no longer subject to disturbing influences exercised by cash-induced changes in the supply of money (in the broader sense).
The main deficiency of all attempts to explain the boom—viz., the general tendency to expand production and of all prices to rise— without reference to changes in the supply of money or fiduciary media, is to be seen in the fact that they disregard this circumstance. A general rise in prices can only occur if there is either a drop in the supply of all commodities or an increase in the supply of money (in the broader sense). Let us, for the sake of argument, admit for the moment that the statements of these nonmonetary explanation
s of the boom and the trade cycle are correct. Prices advance and business activities expand although no increase in the supply of money has occurred. Then very soon a tendency toward a drop in prices must arise, the demand for loans must increase, the gross market rates of interest must rise, and the short-lived boom comes to an end. In fact, every nonmonetary trade-cycle doctrine tacitly assumes—or ought logically to assume—that credit expansion is an attendant phenomenon of the boom.6 It cannot help admitting that in the absence of such a credit expansion no boom could emerge and that the increase in the supply of money (in the broader sense) is a necessary condition of the general upward movement of prices. Thus on close inspection the statements of the nonmonetary explanations of cyclical fluctuations shrink to the assertion that credit expansion, while an indispensable requisite of the boom, is in itself alone not sufficient to bring it about and that some further conditions are required for its appearance.
Yet, even in this restricted sense, the teachings of the nonmonetary doctrines are vain. It is evident that every expansion of credit must bring about the boom as described above. The boom-creating tendency of credit expansion can fail to come only if another factor simultaneously counterbalances its growth. If, for instance, while the banks expand credit, it is expected that the government will completely tax away the businessmen's “excess” profits or that it will stop the further progress of credit expansion as soon as “pump-priming” will have resulted in rising prices, no boom can develop. The entrepreneurs will abstain from expanding their ventures with the aid of the cheap credits offered by the banks because they cannot expect to increase their gains. It is necessary to mention this fact because it explains the failure of the New Deal's pump-priming measures and other events of the 'thirties.
The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.
The essence of monetary theory is the cognition that cash-induced changes in the money relation affect the various prices, wage rates, and interest rates neither at the same time nor to the same extent. If this unevenness were absent, money would be neutral; changes in the money relation would not affect the structure of business, the size and direction of production in the various branches of industry, consumption, and the wealth and income of the various strata of the population. Then the gross market rate of interest too would not be affected—either temporarily or lastingly—by changes in the sphere of money and circulation credit. The fact that such changes can modify the rate of originary interest is caused by the changes which this unevenness brings about in the wealth and income of various individuals. The fact that, apart from these changes in the rate of originary interest, the gross market rate is temporarily affected is in itself a manifestation of this unevenness. If the additional quantity of money enters the economic system in such a way as to reach the loan market only at a date at which it has already made commodity prices and wage rates rise, these immediate temporary effects upon the gross market rate of interest will be either slight or entirely absent. The gross market rate of interest is the more violently affected, the sooner the inflowing additional supply of money or fiduciary media reaches the loan market.
When under the conditions of credit expansion the whole amount of the additional money substitutes is lent to businessmen, production is expanded. The entrepreneurs embark either upon lateral expansion of production (viz., the expansion of production without lengthening the period of production in the individual industry) or upon longitudinal expansion (viz., the lengthening of the period of production). In either case, the additional plants require the investment of additional factors of production. But the amount of capital goods available for investment has not increased. Neither does credit expansion bring about a tendency toward a restriction of consumption. It is true, as has been pointed out above in dealing with forced saving, that in the further progress of the expansion a part of the population will be compelled to restrict its consumption. But it depends on the particular conditions of each instance of credit expansion whether this forced saving of some groups of the people will overcompensate the increase in consumption on the part of other groups and will thus result in a net increase in the total amount of saving in the whole market system. At any rate, the immediate consequence of credit expansion is a rise in consumption on the part of those wage earners whose wages have risen on account of the intensified demand for labor displayed by the expanding entrepreneurs. Let us for the sake of argument assume that the increased consumption of these wage earners favored by the inflation and the forced saving of other groups prejudiced by the inflation are equal in amount and that no change in the total amount of consumption has occurred. Then the situation is this: Production has been altered in such a way that the length of waiting time has been extended. But the demand for consumers' goods has not dropped so as to make the available supply last for a longer period. Of course, this fact results in a rise in the prices of consumers' goods and thus brings about the tendency toward forced saving. However, this rise in the prices of consumers' goods strengthens the tendency of business to expand. The entrepreneurs draw from the fact that demand and prices are rising the inference that it will pay to invest and to produce more. They go on and their intensified activities bring about a further rise in the prices of producers' goods, in wage rates, and thereby again in the prices of consumers' goods. Business booms as long as the banks are willing to expand credit more and more.
On the eve of the credit expansion all those production processes were in operation which, under the given state of the market data, were deemed profitable. The system was moving toward a state in which all those eager to earn wages would be employed and all nonconvertible factors of production would be employed to the extent that the demand of the consumers and the available supply of nonspecific material factors and of labor would permit. A further expansion of production is possible only if the amount of capital goods is increased by additional saving, i.e., by surpluses produced and not consumed. The characteristic mark of the credit-expansion boom is that such additional capital goods have not been made available. The capital goods required for the expansion of business activities must be withdrawn from other lines of production.
We may call p the total supply of capital goods available on the eve of the credit expansion, and g the total amount of consumers' goods which these p could, over a definite period of time, make available for consumption without prejudice to further production. Now the entrepreneurs, enticed by credit expansion, embark upon the production of an additional quantity of g3 of goods of the same kind which they already used to produce, and of a quantity of g4 of goods of a kind not produced by them before. For the production of g3 a supply of p8 of capital goods is needed, and for the production of g4 a supply of p4. But as, according to our assumptions, the amount of capital goods available has remained unaltered, the quantities p3 and p4 are lacking. It is precisely this fact that distinguishes the “artificial” boom created by credit expansion from a “normal” expansion of production which only the addition of p3 and p4 to p can bring about.
Let us call r that amount of capital goods which, out of the gross proceeds of production over a definite period of time, must be reinvested for the replacement of those parts of p used up in the process of production. If r is employed for such replacement, one will be in a position to turn out g again in the following period of time; if r is withheld from this employment, p will be reduced by r, and p — r will turn out in the following period of time only g — a. We may further assume that the economic system affected by credit expansion is a progressing system. It produced “normally,” as it were, in the period of tim
e preceding the credit expansion a surplus of capital goods p1 + p2. If no credit expansion had intervened, p1 would have been employed for the production of an additional quantity of g1 of the kind of goods produced previously, and p2 for the production of the supply g2 of a kind of goods not produced before. The total amount of capital goods which are at the entrepreneurs' disposal and with regard to which they are free to make plans is r + p1 + p2. However, deluded by the cheap money, they act as if r + p1 + p2 + p3 + p4 were available and as if they were in a position to produce not only g + g1 + g2 but beyond this also g3 + g4. They outbid one another in competing for a share of a supply of capital goods which is insufficient for the realization of their overambitious plans.
The ensuing boom in the prices of producers' goods may at the beginning outrun the rise in the prices of consumers' goods. It may thus bring about a tendency toward a fall in the originary rate of interest. But with the further progress of the expansionist movement the rise in the prices of the consumers' goods will outstrip the rise in the prices of producers' goods. The rise in wages and salaries and the additional gains of the capitalists, entrepreneurs, and farmers, although a great part of them is merely apparent, intensify the demand for consumers' goods. There is no need to enter into a scrutiny of the assertion of the advocates of credit expansion that the boom can, by means of forced saving, really increase the total supply of consumers' goods. At any rate, it is certain that the intensified demand for consumers' goods affects the market at a time when the additional investments are not yet in a position to turn out their products. The gulf between the prices of present goods and those of future goods widens again. A tendency toward a rise in the rate of originary interest is substituted for the tendency toward the opposite which may have come into operation at the earlier stages of the expansion.